The SEC’s Regulation Best Interest: Purposes, Components, and Criticisms
Megan Aldworth
Associate Editor
Loyola University Chicago School of Law, JD 2023
In 2019, the U.S. Securities and Exchange Commission (SEC) adopted Regulation Best Interest (“Reg BI”). Reg BI is a standard of conduct that applies to broker-dealers (a firm in the business of selling securities) and persons associated with broker-dealers when making a recommendation of a certain investment strategy or securities transaction to a retail customer. The SEC gave broker-dealers a time window to implement this new law into firm policies and procedures, and while no regulatory action happened in the first few years of its enactment, the SEC brought its first action in June of this year and FINRA brought its first in October of this year. This makes it especially important for broker-dealer firms to ensure they are presently in compliance with the standards set forth in Reg BI.
What is Reg BI?
Reg BI was adopted by the SEC to make broker-dealer transactions and certain investment advising activities more transparent and to protect retail investors from the proprietary interest of brokers and broker-dealers. In the financial industry, a “retail customer” is a person who (1) “receives a recommendation of any securities transaction or investment strategy involving securities from a broker dealer” and (2) then “uses the recommendation for personal, family or household purposes.”
Essentially, broker-dealers and associated persons that are involved in recommending securities to invest in to a retail customer must act in the best interest of that customer when making a recommendation and must not place their own financial interest ahead of that of the customer. Two areas of requirements are at the forefront of this regulation: (1) general obligations and (2) record-making and recordkeeping requirements (the second will not be discussed in this article).
What are the general obligations of Reg BI and what do they entail?
To comply with the general obligations imposed by Reg BI, broker-dealers must follow four subsets of obligations: (1) disclosure obligation, (2) care obligation, (3) conflict of interest obligation, and (4) compliance obligation.
Under the disclosure obligation, those advising investors in retail transactions must disclose material facts about conflicts of interest associated with their recommendations and the scope and grounds of the relationship with the retail investor.
Under the care obligation, broker-dealers must exercise “reasonable diligence, care, and skill” when making recommendations to retail investors. There are a variety of important factors that weigh into a care assessment including the investment strategy objectives, characteristics, liquidity, volatility, and prospective performance as well as the expected return or financial incentives that might be at play in the recommendation.
Perhaps one of the most important of these general obligations is the conflict-of-interest obligation. Under this, broker dealers must “establish, maintain, and enforce” written policies and procedures that identify and disclose or eliminate conflicts of interest. These policies and procedures must lessen conflicts whereby incentive may be created for brokers/advisors to place their own interest, or the firm’s, ahead of those interests of the customer. Further, the conflict of interest policies and procedures must forbid material limitations on offerings from causing firm personnel from putting their own interests ahead of the customer’s (for example, where the firm only offers a limited menu of products that are all proprietary). Additionally, regarding compensation of brokers offering these recommendations, Reg BI eliminates contests, quotas, bonuses and non-cash compensation mechanisms based on the sale of specific securities or types of securities during a certain amount of time. This is in place to limit the proprietary incentives that could outweigh the interests of investors.
The last of the Reg BI obligations is the compliance obligation, which essentially requires broker-dealers to “establish, maintain and enforce” policies and procedures to comply with Reg BI as a whole. Under the compliance obligation, broker-dealers must not only look at existing compliance materials but adopt new ones that establish compliance with Reg BI. Thus, broker dealers must look ahead to ensure satisfaction of new standards for the general obligations.
How Reg BI affects the industry
Reg BI significantly affects nearly all client-facing facets of the financial industry. The transitionary period for this regulation ended in 2020. As a result, broker-dealers must have already established necessary policies and procedures for compliance with Reg BI, especially considering that the SEC, the Financial Industry Regulatory Authority (FINRA) and other state regulators regularly seek express documentation of Reg BI compliance and often examine the policies and procedures of firms to monitor compliance with it.
Criticisms of Reg BI
Since its inception, Reg BI has seen no shortage of criticism. This regulation requires firms to use valuable resources to ensure compliance. Many affiliated with the financial industry assert that Reg BI is easily confused with fiduciary duties already imposed on firms and that this like terminology only serves to defeat clarity. Further, others have stated that Reg BI will not have the intended effect of raising the bar for brokers and that it is not enough because what suffices putting the consumers “best interests” above broker interests is a malleable concept.
Reg BI is a good thing for retail investor protection
Despite its criticisms, history demonstrates why the implementation of Reg BI is important and why creating more transparency in the relationship between brokers and retail investors is important. Brokers registered through FINRA are merely required to comply with a “suitability standard” whereby they must have reasonable grounds on advising a certain trade and make sure it is suitable considering the facts, brokers may make “reasonable” and “suitable” recommendations where the main priority of the recommendation is the size of their own commission. Reg BI aims to rid this issue that FINRA suitability rules leave open and helps retail investors understand the services the broker-dealer offers so that they can compare them to others and make an informed decision on what relationship best suits their investment goals, circumstances, and needs. Lastly, Reg BI enhances consistency in protections offered to retail customers across the financial industry and standardizes protections so that broker-dealers have full knowledge of how to comply and act in the “best interest” of the customer.